Archive for the ‘finance’ Category

Bank Regulation: the answer is transparency

If you haven’t seen yesterday’s epic rant by Paul Mason, Channel 4’s economics correspondent, do now.

But there’s a problem with regulation: it doesn’t work. 

Regulators are never as well-resourced as the banks. So they can’t afford to employ the smartest people. Or not for long, anyway – a good career move is to spend a year or two working at a regulator, then move into compliance with a major bank. Gamekeeper turned poacher.  When you work in compliance at a bank, you’re not a policeman – you wouldn’t last long if you kept on preventing profitable deals (the ones that in the end go to paying your salary).  Your job is to provide the whitewash.

So there’s a brain drain from the regulators to the banks. What’s more,  much of  the young talent working in the regulators has an eye on this career path so won’t do anything to mess it up.  Like get involved in pursuing an enforcement case against a possible future employer.  And the regulators really don’t like pursuing enforcement cases, particularly not criminal ones. The lawyers are lining up on both sides to take their fees, and the banks won’t skimp on paying for the best. If the regulator loses, there’ll be questions asked in Parliament about the waste of taxpayer’s millions, and the banks will be saying “we told you we were perfectly innocent”.  If the regulator wins, the bank puts the cost down as a routine cost of business and fires the compliance officer for failing to apply enough whitewash.

And what were the auditors at RBS doing? Who appoints them? Duh.

There is an answer, though. Less regulation, more transparency.  Much, much more transparency.  So much transparency that it completely changes the way the City works.

No secret deals.  A secret deal is a dodgy deal, so make unenforceable any deal that has any element of secrecy. 

Publish everything IN REAL TIME.

Let us be the auditors with a GoogleBot.

If I can’t find out everything about a deal as it happens,  from my smartphone in the cafe over the road, it’s not transparent enough.

It’s how it used to be.

Well, not quite. But trading was much more public when it was by open outcry on public trading floors. Deregulation and electronic trading came in at about the same time.  Before then, honour – “my word is my bond” – and as much transparency as the technology of the time afforded kept all but the most egregious cases under control.

(And read Stiglitz).




Disguising deflation

A deflationary world

This is a post about the conventional world economy, particularly the USA and the UK.

Both economies have been suffering from low-wage employment growth. Unemployment, normally a clear indicator of a failing economy, has fallen; and so have wages.

Both have had major financial crises and both governments have had to stage bank rescues.

The Eurozone and Japan are also primarily in sync with this movement. The Eurozone has suffered worse because it has had less QE.

There are a few differences, cultural, institutional, but essentially, the whole developed world has been stagnating since at least 2008, with the underlying malaise probably starting as much as a decade earlier.

The facts are that despite the key commodity (oil) being at well-above-average real price levels for most of that time, inflation has remained low and wages have fallen. We have, essentially, been living through deflationary times, saved only by quantitative easing.  Without the actions of both the Federal Reserve and the Bank of England, things would have been much, much worse over the last six years. Unfortunately, QE could not solve the underlying problems and now it is being withdrawn, they are likely to emerge with a vengeance next year.

I could be wrong; I often am and in this case I  really hope so. But I  don’t think so.

Classical economic theory (on all sides of the fence) says that recessions are the consequence of inadequate demand. Keynesian analysis says that the way to deal with that is for government to increase spending and/or reduce taxation during a recession, thus putting more more money in people’s pockets and increasing demand.  These two things aren’t, however, equivalent. On the liberal right, tax-cutting is the preferred mechanism because it lets people, not governments, decide how to spend the money and determine where the demand goes; the interventionist left favours more public works (the Mersey Tunnel, the Tennessee Valley Authority, re-arming for the second world war).  Intervention means that the money is actually spent;  individuals and companies, as is their right,  don’t always choose to do so, particularly when there’s deflation about.  The monetary authorities (central bankers) respond to this by devaluing money, making real interest rates negative. This is normally a strong incentive to spend, after all, why keep the money in the bank losing value? One of the problems of today’s global economy is that consumers, and particularly companies, haven’t been spending their money.

Quantitative Easing (QE): blowing bubbles

QE is a emergency lever used by central bankers to devalue money when the interest rate lever has come to the end of its range.  Global interest rates have been near-zero since the crash.  The central bankers create money to buy bonds from financial institutions. Creating money without creating a corresponding amount of stuff inevitably devalues it, which is the point of the exercise. However, QE has operated at a scale far beyond that originally intended.

The problem with QE is that it is used to buy assets: government securities, commercial paper, and in the US in particular the toxic securitised debt that had triggered the first crisis. This has the result of pushing up asset prices.  Suppose a bank holds $1bn of toxic debt, which it sells to the Fed. The result is that it has $1bn of cash instead of the toxic debt. That needs to go somewhere; held as cash, it will decline in value. So it spends it on other assets. Up to a point, this is a good thing. For related reasons, banks have been under great pressure to “strengthen their balance sheets”, since many had to be rescued during the crash.  New international rules on capital adequacy have come into force and QE has helped them meet the requirements, most clearly in the USA. German refusal to let the ECB do much in the way of QE, allied to the Eurozone’s structure, means that some Eurozone banks have found it harder to pass the new stress tests.    But beyond a point, it is a bad thing: it pushes up the price of assets, creating asset bubbles. There are lots of these around the world, fuelled mainly by dollar QE.  London property is one.  If the bubbles are relatively local, they can burst without bringing the system down.  The market for luxury property in Istanbul – definitely a QE bubble –  has been hit by regional unrest. But the collective effect of asset bubbles bursting is that investors lose money and the effect of the QE evaporates.  A significant factor here is the way insiders offload inflated assets just before the bubble bursts, thus passing off the losses to schmucks, or retail investors as they are more politely known.

The underlying problem is much more serious and none of the actions of the authorities since 2008 have done anything to address it.  It is structural,  based on continued weakness of real productive industries outside the newly-industrialising countries.  Growing income inequality creates a large class of people able to afford only the most basic goods and another, much smaller class of super-rich people with nowhere to put their money. Together, these two groups’ spending isn’t enough to support a prosperous middle-income, working class.  Making money by making useful stuff has been eclipsed by making money from inflating assets. Austerity policies have exacerbated and prolonged the structural problems.

I continue to believe that QE was, perhaps is, a necessary evil, but not a sufficient response to the structural failings of the global economy.  On its own, all it has done is  disguise the intrinsic deflationary phase; that needed addressing by significant state intervention on capital infrastructure projects.

The end of QE without solving the underlying deflationary nature of the economy threatens to bring deflation out into the open. That’s what I’m worried about for next year, although I believe that it’s more likely that central bankers will resume QE to prevent that particular disaster. I really don’t think they have a choice; it’s governments who need to act.

Tax evasion and the deficit: another argument for reform

This article by Eoin Clark makes the case that the total tax evaded under New Labour  is – within ten percent or so – the amount by which the national debt – the accumulated fiscal deficit –   grew over the period.

Therefore, the argument goes, if there had been no tax evasion, there would now be no additional debt, to which we must of course add a giant CETERIS PARIBUS, and an even larger reminder that they never are. Nevertheless, some part of the principle still applies – if more people paid more taxes, the deficits and the debt would have been smaller.

So what are we to do about it? The answer, “deal with tax evasion”, is far too glib. People evade taxes because the tax system is full of loopholes. You cannot simply close them without triggering many unintended consequences….. and it is a fair bet that every loophole is there because some particular lobby group lobbied for for it. Some of them even you will agree with. There has to be a clear exposition of how to deal with tax evasion.

There needs to be a total rethink on what taxes are for, why we pay them, and how we should collect them. Fair taxes, transparently levied on a concrete, objectively-determined base, to pay for an appropriate set of communal services.

Tax avoidance and evasion are possible because we have a broken tax system: one in which tax advisers prosper. Simplify taxation, so everyone pays everything that they should and tax advisers turn their talents to something productive rather than leeching

Note that I am not saying we should outlaw tax advisers. We should just stop having a tax system in which they can prosper by playing off evasion and avoidance – in which there is no demand for tax advisers. The existent of a tax advice profession is a strong indicator of a tax system that is too complex.

Knowledge Management in the Treasury

Douglas Carswell MP discusses here the problem presented by a self-serving Civil Service.

Institutional self-preservation is a universal amongst institutions, and so needs to be discounted in any policies emanating from them. Every quangocrat will explain, with good reason, why their particular quango actually does a good job, and if it didn’t exercise its responsibilities the world would probably collapse. And civil servants like to think that they do a better job than politicians of running the country – which on the whole, they do: since a politician can always be reshuffled or voted out of his job (the former being much more likely),  policy knowledge stays in the Civil Service. Mostly.

But in some departments, it doesn’t – particularly the Treasury. I picked up some insight into this while giving someone who used to work in the Treasury’s knowledge-management function a lift back to London from a weekend music festival (not quite a man in the pub… ). KM, or knowledge management, is yet another activity focused on the active dehumanisation of work – like “human resources” itself. Most organisations have big repositories of knowledge in the heads of the people who work there – it’s why it makes sense for knowledge-based professions, like the law, to be run as partnerships rather than joint-stock companies. But this makes the organisation vulnerable to people leaving, so the aim of KM is to get the knowledge out of the heads of the professionals into some sort of filing system. This way, you don’t need the long formal and informal apprenticeships and you don’t rely on people who know stuff, because the stuff is in the system not with the people.  Anyway, you can see why organisations invest in KM  (and why the big law firms have been big investors in it, because all the big law firms’ partners are hoping that soon they will be able to incorporate, float and make gazillions in an IPO), but I can’t help feeling that they would do better to invest in people.

Apparently, though, the Treasury has a serious need for efficient KM, because people are always leaving. The Treasury recruits bright young graduates in the milk-round from the top universities, and fast-tracks them but still on Civil Service pay scales. As soon as they’ve done a year or two, they tout their CVs round the City and are snapped up by the banks for much more money. There are a few senior managers who have served their time and risen to the level of their incompetence, but no marzipan layer of bright, experienced and ambitious people (because they are all earning much more than the Treasury could pay).  And it has been known for Treasury ministers to bawl out junior civil servants who produce failed old policies as new solutions – in other words, the Minister knows more about the brief than the civil servant.

Ideally, the Treasury should sort out its recruitment and retention, but how? While the banks can still pay so much money, recruitment is always going to go in their direction. Politically, it would be impossible to pay middle-ranking Treasury civil servants bankers’ bonuses and bankers’ salaries, so it must fall back to KM. But surely, all that internal Treasury knowledge is actually ours? So we should be able to read it, shouldn’t we?

Goldman’s Peanuts

I’ve blogged earlier about Goldman Sachs, Paulson, Abacus and Fabrice Tourre; today, Goldman has done a deal with the SEC to clear the slate.

And a very good deal it was too, for Goldman.

The more you look at what Goldman were doing with the Abacus instrument, the clearer it is that it was fraud. But it was what everyone else in the market was doing. Goldman just did it – and does it – better than anyone else. They are all crooks, and Goldman Sachs is the master-crook.

But the SEC was the referee. It called a foul, and it has awarded an indirect free kick against Goldman. Not even a yellow card. Objectively, what they did was full red-card stuff, but everyone else was at it, and the SEC had been turning a blind eye. If it red carded everyone, the whole game would be off.

At the same time, Obama has got his reforms through Congress. Will they be anything like strong enough? Of course not. The clue is in the length of the legislation. The necessary reforms could be done in one page – perhaps even one line:

“if you do not publish and  tell the counterparty  everything that you do, should or could know about the deal in question, it is void”.

Financial Regulation: transparency, stupid.

An interesting late-night rant last night with my lodger, who works for the Financial Services Authority, about transparency.  My points, as a transparency extremist, were my usual ones:

  • opacity is a factor in all cases of financial fraud / irregularity;
  • therefore, as a regulator, the FSA should always be pressing for greater transparency;
  • The regulator should never encourage or require secrecy;
  • technology allows us to be much more transparent than ever before;
  • the regulator should require information to be published as machine-readable realtime datastreams;

His point was that sometimes, a little information is worse than none at all. The example he gave was the FSA risk models (which it uses to asses compliance). Should it publish them? It wants to be transparent, but if it does, the organisations they are trying to regulate will probably (ok, almost certainly) game the system so as to pass their risk models while continuing to behave riskily. Therefore it keeps them secret.

This isn’t satisfactory; besides, there’s a natural justice argument which says that the regulatees have a right to know the rules against which they are being regulated. My answer was that they, the regulator, should be regulating by making publication of key data a condition of regulation.  If this was all they did, it would still make the market much safer. Again, he said that customers aren’t interested in how much Tier 1 or whatever capital an organisation has; which is true. But they are interested in knowing that it’s not going to go titsup while it’s holding their money. If the organisations being regulated were required to publish, in real-time, their financial positions, in a machine-readable, standard format,  plenty of people would write competing smart algorithms to mine the data. If it’s only published deep in the pdf of the annual report, six months after the year end, no-one will bother.  We’d started our discussion talking about the financial aggregators (, etc) . I’m suspicious of these, because their funding model is opaque and commission-based, and they aren’t comprehensive so they don’t do what they say on the tin. You will never find a quote from Direct Line on, so won’t necessarily give you the best deal, just as you won’t find a quote from Ryanair on Opodo or Expedia. But a financial aggregator using a different business model (commission is almost always the wrong incentive) could very usefully assess the financial stability of its members if they were to provide it with a feed of the necessary information in electronic form.

It’s simple.  Perfect competion demands perfect information; there isn’t perfect information, so the market is not perfectly competitive. But technology frees information, so it should be used to make the market more competitive.

ponzi schemes

Continuing my ramblings about commission, I refer you, gentle reader, to my earlier posts about Bernard Madoff.

Madoff operated a classic Ponzi scheme, and in my earlier post I postulated that the market as a whole had done the same to its participants, largely as a result of commission.

A classic, or simple, Ponzi scheme, is an investment product producing above-average returns to early adopters by siphoning-off the deposits made by new investors. So long as the scheme continues to attract new depositors, investors get a good return; but it is as fraudulent as a chain letter. It is, of course, exactly the same thing, but less honest. At least with a chain letter you are told how it works, but the inexorable arithmetic is the same in both cases. Madoff made his scheme last for so long by providing only slightly above-average returns, which both made it seem more credible and extended the time-scale of the inexorable arithmetic.

I think that in addition to the simple Ponzi scheme used by Ponzi, Madoff and many others, it is possible to conceive of complex Ponzi schemes. A simple scheme is implemented in a self-contained financial instrument, whereas a complex scheme does the same thing using multiple instruments where the value flows between them; but from the outside, the effect is the same.  A complex scheme could then be either contrived or emergent. In a contrived complex Ponzi scheme, the operators of the various instruments deliberately set out to achieve the Ponzi effect and design them to do so. I think that some of the housing/buy-to-let/mortgage frauds may be contrived complex Ponzi schemes; estate agents, solicitors and mortgage brokers are typically implicated in a conspiracy to defraud.

Much more disturbing, however, is the case of the emergent complex Ponzi scheme. In this case, it is the interaction of various financial instruments, each of which is itself entirely legitimate, which leads to a Ponzi effect. One such instrument might be broker’s commission. Indeed, I suspect it is the main villain in my very strong hunch  that most of the financial services sector has been operating for much of the last quarter-century as a very large emergent complex Ponzi scheme. Not a deliberate, criminal enterprise, but one nevertheless where the operators have benefitted enormously as punters have lost.  I suspect that it is a property of commission-based sales in savings products that a complex emergent Ponzi scheme is inevitable.

Perhaps there is evidence for this, but I think that first I need an adequate algebra to make the case and then to derive relations which can be tested against available metrics.

Sales Commission and Market Failure

Time to give those “poor” MPs a rest, and consider another issue which might be germane.

Most insurance-based savings products, such as pensions and endowments, are sold on commission. There is a saying in the insurance industry that insurance is never bought, it is always sold.

In the recession of the early 1980s, and again in the early 1990s, commission-based sales jobs were always on offer. You could earn a lot of money selling life-insurance, but most people I knew were never so desperate as to sacrifice their integrity that far. The jobs were entitled “financial adviser”, but the only skill the “adviser” needed was rote-perfect knowledge of the policy sales pitch. The jobs were sales jobs, pure and simple: If you didn’t sell any policies, you didn’t make any money, and to the punter, commission was the hidden cost of “free” financial advice. “Advisers” were forbidden to disclose the level of their commission; so since solicitors were required by the Law Society fully to account to their clients for any commission they were paid on products bought on their behalf,  many life companies refused to sell through solicitors.

Some time before that, the cosy City club of life insurers had an agreement about the maximum levels of commission they would pay their sales people. Today, such an agreement would be unlawful; but back then, it was binding on its members. However, a small City merchant bank, Hambros, set up a life department and didn’t join the life insurer’s club. After all, Hambros were already a member of the Accepting Houses Committee (which had nothing to do with life insurance, but was another cosy City club). Hambros decided to ignore the maximum commission rule, and pay its sales team much higher commission than anyone else. This was a very successful strategy, and Hambro Life quickly became bigger than its parent.  Hambro Life eventually became Allied Dunbar. The interesting thing about this is that Hambro Life grew its market share only by paying its sales staff high commission. It had nothing to do with the benefits to policy holders.

All the major life offices paid commission to their sales staff. The main exception was the Equitable Life, whose sales staff were paid salaries.  Unfortunately, shorn of the incentive of commission, they were less succesful, so the Equitable resorted to sweetening its sales offering with a promise (a guaranteed annuity rate) that would eventually destroy the organisation.

The lack of transparency in commissions led to many abuses. Various systems of regulation were imposed over the years, with the life offices fiercely resisting commission disclosure for years. Now, however, commission must in most cases be disclosed. There is no such thing as free financial advice, and independent financial advisers started charging fees, offsetting them against the commission they received.

One of the biggest problems emerged with endowment mortgages. Endowment mortgages used to be quite a good idea, for tax reasons. There used to be a 50% tax credit for life insurance premiums, and there was also full tax relief on mortgage interest.  So if you took out an interest only loan, the interest is payable in full for the full period of the loan, and the tax relief would be continuing, whereas with a repayment mortgage the interest (and thus the tax relief) reduces over time.  Tie in an endowment policy, with its 50% tax relief, to deal with the principal of the loan, and you had a product that, in theory at least, could save the borrower some tax. However,  tax credit on life insurance premiums was abolished in the 1980s, and mortgage interest tax relief was curtailed (it, too, is now abolished).  This made endowment mortgages much less efficient; but they were entrenched. Estate agents were paid commission for arranging endowment mortgages; lenders regarded the additional security of a life policy as justification for increasing the loan-to-value ratio beyond the 85% with which they had been comfortable in the past, and everyone benefitted, except of course those who bought such policies. It quickly became apparent that they were never going to pay out the full value, and it was clear that most endowment mortgages sold after about 1988 were mis-sold.  Many of the brokers who mis-sold them were commission-only agents. My partner and I were one of many victims of this; we received no compensation because we had changed the mortgage to a repayment basis and weren’t going to suffer unduly. Apart from having a life policy that we had bought on the firm assurance (an express promise from the long-vanished broker) that on maturity it would pay out at least the full value of the mortgage, and is worth less than we have paid for it in total.  The endowment fiasco was certainly a prime example of commission-based sales causing market failure.

Endowments and pension products are basically the same thing. Commission disclosure seems to me to be a sine qua non for any commission-based sales, but I would say that wouldn’t I, and  it’s not really enough. After all, when I bought my duff endowment mortgage, I knew the broker was going to get most of my first year’s endowment contributions, even if I didn’t know exactly how much; I still bought the policy. The problem is that it inevitably distorts “best advice”.  There are rules about what financial advice advisers can give, which de-skills them and reduces a complex subject to a series of regulated tick-boxes. It’s going to be hard for a broker or adviser to advise against buying a savings product, even if objectively such advice is the best for the client concerned, when to do so means that he will not be paid. It demands an unrealistic expectation of the adviser’s integrity.

Commission creates a short-term/long-term mismatch, and this is really where it goes wrong. I’m talking here just about long-term regular savings contracts like endowments and money-purchase pensions, but we will see how the problem extends to all commission based sales, including vanilla stockbroking.  As a saver, my interests lie in the long-term performance of the product, whereas my adviser’s interests like in the attached commission.  Twenty-five years’ time matters for me, not for the broker. So a first step could be to require an alignment of interests. If my broker is to get commission, it should be paid in the form of units in the fund backing the policy he sells me. If he needs money now, he can borrow it at commercial rates against the security of those units, just as I have done for my mortgage.

Tax and Transparency

Of course, I should be doing my tax return.

Instead, I’m thinking about tax in the abstract.

It’s no secret that our tax system is broken. Broken here, in the UK, and just as badly broken in most other countries of the world. The strongest evidence is that in most countries, despite tax systems that are intended to be progressive,  the rich pay proportionately less tax than the poor.  They manage to do so because tax systems are too complicated, so that at high tax levels (I didn’t say the rich pay less tax than the poor, although, in aggregate, they do, because there are fewer of them, but that they pay proportionately less) it is worth paying a tax professional to reduce one’s tax bill.

The viability of professional tax-reducers is a strong indicator of an over-complex tax system. The more numerous and successful the tax profession in a broadly compliant economy, the more complex the tax system.

So why is tax so complicated? I think the main reason is that we tax the wrong thing. Tax is levied (mainly) on  income, which seems – at first sight –  eminently fair. But what is income? If you get paid a salary, or dividends from savings, it’s easy to see – it’s the big number on your payslip. But if you run any sort of business, you can deduct your business expenses. What’s allowable?  This is the first area of fertile ground for a tax professional.

Now, what about capital gains? So we have to invent a whole new tax to cover capital gains, because capital gains aren’t income.  Depending on whether capital gains tax is more or less than income tax, tax professionals can be called in to classify every receipt into its most favourable category.

Instead, in my opinion, we should be taxing cash flow. Cash flow is clear and easy to define and to measure. There’s no need to distinguish cash realised from disposal of an asset from cash in a paycheque.  For individuals, the only deduction would be cash invested, either as equity in a corporation, or into bonds.  In this radical new world, because it is radical, corporations wouldn’t pay any tax at all: but, instead, would be required to be *totally* transparent.  All money leaving the corporation (whether as salaries, dividends, bond interest, or on the sale of stock) would be taxable.

a new saw

An investment vehicle that consistely produces above-average returns without fraud is as likely as a perpetual-motion machine.